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Online Extra: Time to End "Friends-and-Family" Shares

When Seagate Technology (STX) went public in December, the giant drivemaker took an important stand. Unlike most initial public offerings, Seagate declined to offer any friends-and-family shares. These are the coveted shares issuers and their bankers can quietly offer to whomever they choose -- be it cousin Jack or the president of XYZ Corp. From Seagate's standpoint, a friends-and-family plan wasn't worth the hassle.

Sure, it might have been a nice way to thank faithful allies. But Seagate worried about who would -- and wouldn't -- get a piece of the deal. Executives also were concerned about fostering any perception that its stock offering was as much about lining the pockets of friends as it was about raising capital. "It was a no-win situation," says Seagate' Chief Financial Officer Charles C. Pope. Too bad most companies don't see it that way -- which is why federal regulators need to adopt an outright ban on friends-and-family programs.

FOLLOW THE MONEY. Compelling evidence shows that these relatively small stock allocations -- usually little more than 5% of an offering -- can be the source of big problems. Consider this: Companies tend to hand out stock only if their "friends" can make money on it. That gives bankers and execs an incentive to underprice deals, which improves the chances that an IPO will jump when it starts trading.

Of course it's hard to talk about underpriced IPOs in today's slumping market, in which new offerings are rare. And the concept of an underpriced stock, it's now all too clear, is only relative.

When IPOs come back, the distortions brought on by friend-and-family shares are all too likely to accompany them. Indeed, research shows that as the percent of IPOs with these plans goes up, so does the first-day price spike in an average new offering. In 1996, when the average spread between offering and first-day closing price was 16%, just 24% of IPOs had friends-and-family allocations, according to Jay R. Ritter, a professor of finance at the University of Florida. But in 1999 and 2000, when 79% and 93% of all IPOs had these plans, respectively, the runup in price was 71% and 57%, respectively, on the first day of trading.

TIME TO ACT.The result is that a few individuals can reap a windfall, while shareholders and companies raising capital get shortchanged. Ritter's research shows that underpricing IPOs cost companies an aggregate of $6.45 billion in 1996 and more than $35 billion in 1999. Even when the market began to sag in 2000, some $27 billion was left on the table, meaning companies didn't have that cash to invest in things like research and development or marketing.

The temptation to hand out preferential shares to influential managers in key decision-making positions is, for some, irresistible. As a four-month BusinessWeek investigation demonstrates, the conflicts created by an individual's personal financial stake in business partners can result in behavior that hurts both the employer and shareholders.

"Conflicts of interest can give an incentive to act improperly," says

Kirk O. Hanson, an ethics professor at Santa Clara University. This may sound like a bunch of yesteryear hooey. It's not. Experts say the cycle of stock handouts will begin anew the minute business smells an upturn on Wall Street. Instead of waiting for that, Washington should stop the giveaways before more companies -- and shareholders -- get snookered by the next wave of IPOs. Commentary by Linda Himelstein, who covers high tech for BusinessWeek from Silicon Valley

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